Kay Review: The Problem of Short-Termism in UK Equity Markets
Sarah Jane Leake | Bloomberg Law
Last year, the Department for Business, Innovation & Skills (BIS) commissioned an independent review, chaired by Professor John Kay, into the incentives, motivations, and timescales of participants in UK equity markets, and their impact on corporate decision-making and the long-term performance of UK companies.1
The review comes in response to concerns that short-term incentives and pressures may be damaging to the way in which companies are owned and managed. “[I]t is sometimes forgotten,” argued one stakeholder, “that equity markets exist not solely to enrich speculators, market makers and intermediaries . . . . It would seem fair to say that equity markets today serve the needs of the players in these markets better than they serve either those who put up the money or the businesses wanting finance to support growth.”2
While steps have been taken to improve shareholder engagement with companies,3 many have commented that interaction has deteriorated.4 This is a serious failing, since, according to Kay, “stewardship is the only means by which, taken as a whole, the financial services sector can discharge its responsibilities to those who entrust funds to it.”5
Kay has recently published an interim report summarising submissions received in response to last September’s Call for Evidence.6 Notably, the report sets out the case for restraints on short selling and high frequency trading (HFT), considers changes to the quarterly reporting regime, and proposes greater transparency on excessive asset management fees. In the wake of the hostile takeover of Cadbury Plc by Kraft Foods Inc.,7 the report also seeks out ways in which to enable the rejection of takeover bids that may be in the interests of some investors but do not promote the success of the company. Kay also touches on problems arising out of the way in which compensation packages are structured, as well as diversity in the boardroom, although these issues are being taken forward in separate reviews.8
Company & Board
Section 172(1) of the Companies Act 2006 requires directors to promote the success of the company for the benefit of the shareholders as a whole, with regard to, among other things, the likely consequences of any decision in the long term. Interpreting this duty, however, becomes particularly difficult in a takeover scenario, especially when the directors of a company suspect that the potential acquirer will not protect the long-term interests of the company.
Sir Roger Carr, former chair of Cadbury, who stood down shortly after the takeover, has stressed that the Cadbury board did not think it was possible to reject Kraft’s offer, which reflected full value for the business, even if it considered the acquisition not to be in the long-term interests of the company. Moreover, would it have mattered had the board done so anyway? Arguably, such a bid was unlikely to have been rejected by the company’s shareholders in any event, particularly given that, in recent transactions, a significant proportion of shares in the target company had been owned by arbitrageurs solely seeking a “rapid, profitable exit.”9
To facilitate the rejection of bids that do not promote the long-term success of the company, Kay suggests:
- Giving directors greater discretion to reject unsuitable bids. There is a danger, however, that this may lead to managers protecting their own interests at the expense of shareholders and other stakeholders.
- Referring the issue for formal governmental review, but this could only be done where competition issues arise (as has been the case with the audit market10).
- Lowering (for the bidder) or raising (for the target) the threshold at which shareholder approval of a bid is required.
- Differential rights for shareholders.
In Kay’s view, the latter is the most feasible, and potentially the easiest to implement. Shareholders who acquire shares after the announcement of a takeover bid, for example, could be disqualified from voting on the bid. This would reduce the influence of arbitrageurs on the outcome of the bid process. Alternatively, shareholders could acquire enhanced voting rights after holding their shares for a certain number of years, either mandated though legislation or implemented by companies themselves through their articles of association.
It must be noted, though, that the Panel of Takeovers and Mergers, the body responsible for supervising and regulating takeovers in the UK, dismissed the idea of disenfranchising the owners of shares acquired during offer periods in its review of the City Code of Takeovers and Mergers (Takeover Code) in 2010.11This is on the basis that all ordinary shareholders should have the same rights.12 Moreover, there is a risk that, if shareholders were not treated equally, some who did not receive the advantages given to others may be discouraged from entering the market.
While many respondents to September’s Call for Evidence argued that taper relief (on capital gains tax (CGT))13 could be reintroduced to benefit long-term shareholders, Kay points out that CGT is only relevant only for a minority of shareholders in UK companies and that its main effect is on UK resident individuals who directly own shares. Even so, those who do hold shares directly do so though individual savings accounts (ISAs) or self invested personal pensions (SIPPs), on which no liability to CGT arises.
Within the asset management sector itself, Kay identified several obstacles to successful stewardship, including:
- The “tyranny of the benchmark,” where asset managers are assessed relative to their peers based on benchmarks, using a shorter time horizon than that over which the saver looks to maximise return.
- The lack of incentives for asset managers to engage with companies. Despite the fact that the asset manager incurs all the cost, the additional return accrues to other firms (otherwise known as free riders). Some stakeholders suggest introducing a distinct charge or levy on all investors to pay for the costs of engagement.
- Fragmented ownership, which could be mitigated or reduced by conferring advantages on shareholders who engage, encouraging shareholders to act collectively, using multiple classes of shares to create less dispersed patterns of shareholding, and/or incentivising fund managers to hold more concentrated positions.
Furthermore, some criticism was levelled at the Stewardship Code, for placing too much emphasis on the formalities of engagement rather than on the substance of board appointments and decision-making. It is likely that this issue will be looked at more closely during the Financial Reporting Council’s review of the Code later this year.
The proliferation of intermediation in UK equity markets – by asset managers as well as investment banks, consultants, advisers, custodians, trustees, administrators, and distributors – is also referred to as hindering long-termism in the UK’s equity markets. Feedback to the Call for Evidence criticised, in particular, the increasingly steep costs of intermediation (especially investment bankers’ fees), the potential for conflicts of interest, stock-lending, and the short-term focus of analysts. Is the value provided by these intermediaries, Kay asks, commensurate with their costs, and should fiduciary duties need to be employed more widely in the investment chain? Any rewriting of directors’ duties would, however, be a long and complex process and, as such, is not likely to take place in the immediate future.
Measurement & Reporting
In Kay’s view, steps to enhance transparency in terms of corporate reporting have been taken too far. “Less may mean more,” he opines, “and more may mean less.”14
The imposition of quarterly reporting for listed European companies15 some five years ago has, according to Kay, done little but confuse both managers and investors. The report explains that a significant number of companies and investors consider quarterly reporting and interim management statements to amount to “useless or misleading information”16 and to be excessive and disproportionate for many businesses. Apart from the administrative burden, quarterly reporting is said to have increased focus on “making the numbers” at the expense of long-term growth and development. One experienced chief executive advised that “the pressures of frequent reporting encourage an emphasis on short term actions.”17 Many stakeholders admit that where mandatory or conventional reporting requirements are relaxed, they are in fact more inclined to pay more attention to communicating better targeted information in a more meaningful fashion. The wide consensus that quarterly reporting has adverse effects on the behaviour of companies and investors is reflected in the European Commission’s recent proposal to abolish this requirement as part of a wider review of the Transparency Directive.18
Kay also notes a number of other factors that have helped reduce the number of traditional long-term holders of equities, including mark-to-market accounting (which is seen to have accelerated the closure of defined pension schemes) and Solvency II19 (which has caused many UK insurers to reduce their holdings of equities).
Concern was expressed at the large number of foreign companies currently listed in the UK.20 Many commented that they “lower the tone”21 of the UK equity market; the growth of companies of low quality in London markets has, to some investors, reduced the attractiveness of all equity investment, and especially its appeal to the long-term committed investor. Yet, Kay stresses that the undue weighting investment portfolios give to foreign companies listed in the UK is often a choice that the funds themselves have made and, to this end, queries whether fund managers should be encouraged/required to change their own rules.
Rapid technological change is also seen to have brought new pressures to UK equity markets. Statistics suggest that HFT now represents more than half of volume on the London Stock Exchange, and it is held responsible by some for the low spreads now quoted on many popular stocks. While many respondents to Kay’s Call for Evidence were hostile to HFT, viewing it as a barrier to long-termism, there were few proposals as to how the volume of such trading or the activities of traders in this area could be reduced. One proposal that might be developed further is to require orders, when placed, to rest for a minimum period of time. The Government Office for Science (GOS) is currently undertaking a project examining the future of computerised trading in financial markets,22 and Kay’s final report will be shaped around GOS’ conclusions.
Significant criticism was also levelled at short selling, with many arguing that the practice of short selling a company’s shares inhibits that company from taking long-term decisions. While significant lobbying has been undertaken to further restrain short selling, it is uncertain as to whether the UK would impose super-equivalent provisions in addition to those soon to be imposed at EU-level via the Regulation on Short Selling,23 which was adopted by the European Council on 21 February and is expected to come into force in 2012.24
The consultation closes for comment on 27 April and, shortly thereafter, Kay will publish his final report setting out formal recommendations to the Government. It is anticipated that some of the recommendations will need further consideration by several governmental bodies, with appropriate legal competencies, in order for them to be taken forward.
Caution, however, must be exercised. As stressed by the Institute of Directors (IoD), the UK body that represents and sets standards for company directors, any unilateral policy measures designed to redefine the time horizons of institutional investors will encounter difficulties, not least because they “are likely to be largely impotent in a world of global capital markets.”25 It is therefore important in the next stage of the review that the solutions carried forward will not disadvantage the City of London and weaken its competitive edge on the global stage. To this end, a better solution, suggests the IoD, would be to focus more on improving the education and training of directors.
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